The Next Big Thing In Corporate-Tax Avoidance

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It’s no secret that big corporations are adept at paying as little in taxes as possible, and that one of the most commonly used strategies for tax avoidance is keeping profits earned at foreign subsidiaries abroad in order to escape the U.S.’s relatively high corporate tax rate on those earnings. But according to a recent article in the Wall Street Journal, it turns out that these firms are actually able to tap this cash after all, simply by taking out loans and using foreign cash as collateral. According to the Journal

“U.S. multinational companies routinely set up units in low-tax jurisdictions to pool cash from their global operations and lend to other parts of the business, tax lawyers and corporate treasurers say. These units operate as internal banks or captive commercial-paper markets, they say, facilitating intracompany lending and charging and paying interest rates along the way.”

The IRS sets strict rules governing this behavior, however. The loans must be short term. Their maturities cannot remain outstanding for more than 30 days after the fiscal quarter in which the loan was issued ends, but companies are generally able to borrow liberally from subsidiaries if the loan terms are restricted to one fiscal quarter, according to the Journal.

(MOREThe Corporate Tax Rate Is Lowest in Decades; Is Business Paying Its Fair Share?)

Companies engaging in these tactics surely can’t be blamed for attempting to minimize taxes, but this sort of behavior just underscores the absurd incentives that are written into our corporate tax code, which is badly in need of reform. The share of the federal government’s revenue that comes from corporate taxes has been steadily declining for years, and much of that has to do with large firms’ increasingly global presence and ability to manipulate their operations across different tax jurisdictions to pay as little as possible.

Some economists have proposed that we should do away with the corporate tax altogether, and shift the tax burden onto the owners of corporations, i.e. the shareholders. After all, it doesn’t make a lot of sense to tax corporate profits and then tax them again when those profits are returned to shareholders in the form of dividends. Raising capital gains rates and doing away with the corporate tax would reduce corporations’ incentives to waste time and resources concocting these short-term loans and other overly complex tax-avoidance schemes.

But doing away with the corporate tax isn’t a politically tenable proposal at a time when corporate profits are at an all-time high and wages are stagnant or falling. There’s a good argument for having corporations as entities share some of the burden for funding government. After all, corporations are allowed to donate to political campaigns, and they take advantage of public services like infrastructure and education. In addition, there is not a direct relationship between corporate profits and shareholder gains, as corporations can hold on to their earnings indefinitely. But if we’re going to continue to have a tax on corporate profits, we need to reform the tax in such away that so many resources aren’t wasted on these Rube Goldberg-like mechanisms for tax avoidance.

(MORE: Should Uncle Sam Be Doing More to Get His Hands on the $1.7 Trillion U.S. Companies Hold Overseas?)

As I’ve written before, much of the absurdities of the current tax code could be avoided by moving to a corporate tax system that uses “formulary apportionment.” Under that system, companies would be liable for taxes based on the number of goods they sell in a particular country. It wouldn’t matter where a business is headquartered, or where it keeps its excess cash. Taxes would be levied simply on where its products or services are being sold.

It helps to remind ourselves that the rise in corporate cash being stashed isn’t just a product of corporations wanting to avoid taxes. It’s also the result of multinational firms’ increasingly global presence and the fact that a lot of economic growth is happening outside the U.S. Corporations are going to keep their cash where the opportunities for growth are best. And the changing global economy means policymakers are going to have to change the way they approach taxation and globalization. Instituting a system of formulary apportionment for corporate taxes is a great place to start.

MORE: We’re #1! U.S. Officially Has the Top Corporate Tax Rate. Or Not.